FREE Policy Brief Series

What Does Modern Political Economics Tell Us about the Fate of Russia’s Reforms?

Sergei Guriev, NES/CEFIR September, 2011

After the 2008-09 crisis, Russia is facing a new set of challenges. The pre-crisis sources of growth have been exhausted. In order to implement its growth potential and catch up with OECD countries, Russia must improve its investment and business climate. Although the reform agenda has been repeatedly discussed, it is not being implemented. The explanation is provided by modern political economics: what is good policy (in terms of social welfare and growth) is not necessarily good politics (for a country’s rulers). In this sense, modern Russia is a perfect example of the non-existence of a political Coase theorem. Although everybody understands that the status quo is suboptimal, the most likely outcome is further postponement of reforms.

Whither Russia? book’s different chapters arrived at similar conclusions, which might be summarized as follows: while Russia came out of the crisis in In 2009, the New Economic School joined the a reasonably good shape and has nothing to Russia Balance Sheet project launched by two fear in the near term, it has serious long-term DC-based think tanks: the Center for Strategic problems that need to be addressed as soon as and International Studies and the Peterson possible; however , it is unfortunately the case Institute for International Economics. The aim that Russia is unlikely to implement the of the project was to assess Russia’s assets and required reforms, since they go against the liabilities. Similarly to compiling a company’s interests of the ruling elite. balance sheet, the project estimated the potential for long-term development and This argument is especially clear with respect growth, and the problems that could prevent to Russia’s economic problems – that Aleh Russia from realizing this potential. Tsyvinski and I analyzed in the first chapter of the book. In the short run the Russian The main output of the project in 2009-10 was economy is certainly doing quite well. So long the book “Russia after the Global Economic as oil prices stay high, the budget remains Crisis”, which was published in English in the balanced, the economy grows, and sovereign Spring 2010 and in Russian in the fall of the debt is virtually non-existent (in marked same year. The book looked at a broad range contrast with debt burdens of OECD of issues that could be classified as Russia’s countries). Contrary to what is claimed by “assets” and “liabilities”, extending from many critics of the government, pre-crisis economic, political and social issues to energy, growth did trickle down to all parts of Russian foreign relations, climate change, innovation society, and that has ensured that the and military reform. Interestingly, despite the government enjoys sufficient political support. breadth of the analysis, the authors of the

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However, in the long run, the situation is very theorem are not met in the instance of political different. The pre-crisis sources of economic economy, which we are considering. In our growth (rising oil prices, low capacity case the ruling elite does not merely trade utilization and an underemployed labor force) goods or even assets: by allowing reforms it have all been exhausted. Oil prices are high, would lose the power to expropriate and but are unlikely to rise much further. protection from being expropriated. Production capacity and infrastructure are Unsurprisingly, there is no “political Coase over-utilized. The labor market is very tight. In theorem” (see Acemoglu, 2003). order to grow at the rates, which Korea and other fast-growing countries achieved when As we discuss in Guriev et al. (2009), this they were at Russia’s level of development, problem is particularly acute in resource-rich Russia needs new investment. Hence, Russia transition economies without established has to improve the business climate and the political and legal institutions. In such investment climate. This, in turn, depends on economies, the lack of institutions means that reducing corruption, improving protection of the rulers are less accountable and can property rights, building an effective and therefore appropriate a large share of the independent judiciary, and opening the resource rents. The resource rents increase the economy to competition (both domestic and incentives to hold on to power and provide the international). rulers with the resources which they need in order to maintain the status quo.

In the opening chapter of “Russia After the Good Policy, Bad Policy Global Economic Crisis”, Aleh Tsyvinski and myself argued that this is precisely Russia’s problem. We punningly defined the status quo The changes that are needed in order to ensure as a “70-80 scenario”: if the oil price stayed strong growth are obvious, but they are fairly high ($70-80 per barrel) then Russia unlikely to happen. The reason is very simple: would be likely to follow the 1970-80s the political equilibrium is such that Russia’s experience of the Soviet Union, when reforms political elite is not interested in change. There were shelved and the economy stagnated. That is nothing unusual about this. As Bueno de period ended with the bankruptcy and Mesquita et al. (2003) have argued: good disintegration of the Soviet Union. policy may be bad politics and vice versa. If achievement of economic growth depends on Certainly, the differences between modern surrendering control over the commanding Russia and the 1970-80s Soviet Union are heights of the economy (through privatization, substantial. Although the government controls strengthening the rule of law, deregulation, the commanding heights of the modern and encouragement of competition), the ruling Russian economy, the nature of the latter is elite may fear a weakening of its hold on capitalist and not command. Also, Russian power and ultimate loss of power as the price economic policymakers are much more of achieving growth. In this case, the ruling competent and, unlike their Soviet elite will prefer to stay in charge of a predecessors, they can easily believe that if a stagnating economy (and enjoy a big piece of a country runs out of cash, the government is small cake) rather than risk losing power (and removed from office: they have seen it happen having no piece of a bigger cake). to those same Soviet predecessors.

Can society somehow buy out the vested This brings us to a conundrum: if it is clear interests of the rulers? One of the most that the status quo is a dead-end, what is the powerful theoretical results in economics, the ruling elite hoping for? On the one hand, the Coase theorem, would suggest that the answer elite understands all too well that reforms are is yes. However, the conditions of the Coase risky – everybody remembers the last Soviet

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government, which initiated change and lost abundance is important as it helps to feed the power as a result of that change. On the other over-optimism: the fortunate leaders that rule hand, it is clear that in order to remain in during the period of high oil prices can easily power the government needs growth and that believe that their luck is permanent and their growth can only come from reforms. belief (or, as the leadership literature calls it, “vision”) will be consistent with the evidence – but only until the oil price plunge.

Rational Overconfidence

The 70-80 Scenario: Two Years The solution to this conundrum is to be found, not in modern political economics, but in the On realm of behavioral economics and studies of leadership. In recent years, economists have We started to write the 70-80 chapter in the been keen to integrate insights from fall of 2009, when the oil price was already psychology into their models of markets and back from $40 per barrel to the fiscally organizations. comfortable range of $70-80 dollars. What has Psychologists know very well that human happened since then to the likelihood and beings want to be happy, and are therefore sustainability of our scenario? disposed to forget bad news and remember What we find is that, although the 70-80 pun only good news. They also like to persuade no longer works, our main argument has been themselves that they are good (or at least better reinforced. First, the oil price is no longer in than others). This explains why investors the range of $70-80 per barrel, but has risen always want to believe in more optimistic higher due to events in the Middle East and scenarios (hence bubbles, see Akerlof and Japan, as well as increased demand for oil as a Shiller, 2009). Furthermore, a certain degree store of value reflecting diminished confidence of over-optimism on the part of leaders is in dollar and euro assets. Second, the Arab actually “rational” or “optimal” (see Van den Spring has made the Russian government Steen, 2005, and Guriev and Suvorov, 2010). suspect that its hold on power is more tenuous Over-optimistic leaders are more resolute, and than it previously believed, and it has started they attract more capable and enthusiastic to spend even more aggressively. Russia’s followers. In this sense, in an environment budget is no longer in surplus at $70 per with weak political institutions, over- barrel: it can now only be balanced if the oil optimistic political leaders always crowd out price is at $125 per barrel (!). In this sense, more realistic leaders (who do not promise as $70-80 per barrel is no longer a “high” price – much). Where there are strong political it is both below the current market’s institutions that ensure political accountability expectations and below the Russian (e.g. via political parties), this behavior is not government’s fiscal benchmarks. sustainable. But if there is no accountability, over-optimism almost inevitably prevails as a However, our main argument has been result of political selection. reconfirmed. High oil prices have encouraged the Russian government to become further This may explain why the Russian political entrenched in the status quo scenario. While leadership hopes for the better. So far the there has been a substantial increase in rhetoric model “whenever we are in trouble, the oil about privatization, deregulation, competition, price goes up and saves us” has worked, and it rule of law etc., actual change has been will keep working until the oil price goes lacking. On the contrary, there is increasing down and undermines both macroeconomic reliance on government ownership and and political stability. Once again, resource

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increasing probability that Russia will move Peterson Institute for International Economics. further down the road to stagnation after the Washington, D.C. presidential elections of 2012. Bueno de Mesquita, Bruce, Alastair Smith, Randolph M. Siverson, and James D. Morrow (2003). "Logic of Political Survival". MIT Press. Can There Be An Alternative to Gilbert, Daniel (2006). "Stumbling on Happiness". Stagnation? Knopf. Guriev, Sergei, Alexander Plekhanov, and Konstantin Sonin (2009). “Development Based on Commodity In “Russia after the Global Economic Crisis” Revenues.” European Bank for Reconstruction and Development Working Paper No. 108. Available at we also charted an alternative scenario based SSRN: http://ssrn.com/abstract=1520630 (Also available on reforms that help to realize Russia’s as Chapter 4 in the Transition Report 2009). substantial growth potential. Is this scenario Guriev, Sergei, and Anton Suvorov (2010). “Why Less feasible? Certainly, the laws of political Informed Managers May Be Better Leaders.” Available economy are not deterministic. Even though at SSRN: http://ssrn.com/abstract=1596673 the status quo path is preferable for the Van den Steen, Eric J. (2005). “Organizational Beliefs and Managerial Vision.” Journal of Law, Economics, country’s rulers, a leader (or a sub-group in the and Organization, 21: 256-283. elite) may emerge who is long-term-oriented and is not over-optimistic. If this leader or group manages to create a critical mass of stakeholders for reforms, there may be a “run” Sergei Guriev on the status quo. For example, if the oil price Centre for Economic decreases and there is fiscal pressure to and Financial privatize, then a critical mass of private Research (CEFIR) owners may emerge who are interested in [email protected] protection of property rights and the rule-of- www.cefir.ru law.

However, even though a positive scenario is Sergei Guriev is a Professor of Economics and possible, it is not very likely. Investors have Rector of the New Economic School in Moscow, as already reached this conclusion: Russia has well as President of the Center for Economic and been experiencing large capital flight since the Financial Research at the New Economic School. fall of 2010 (net capital outflow is about of 5% He is also a Research Fellow at the Centre for of GDP). Investors are not yet ready to bet Economic Policy Research, London. their money on the good scenario. Nor would Dr. Guriev has published in international refereed political economists recommend them to do journals, including the American Economic so. Review, the Journal of European Economic Association and the American Political Science ▪ Review. He is also a columnist for the leading Russian business daily, Vedomosti, and the monthly, Forbes Russia.

Referenses Dr. Guriev is a Member of the President of Russia's Council on Science, Education, and Technology in Acemoglu, Daron (2003). "Why Not A Political Coase Russia, a Member of the Board of the Dynasty Theorem? Social Conflict, Commitment, And Politics," Foundation and a Member of the Board of Journal of Comparative Economics, 31: 620-652. Directors of the Sberbank, Agency for Home Akerlof, George A., and Robert J. Shiller (2009). Mortgage Lending, Russian Venture Company and "Animal Spirits: How Human Psychology Drives the Alfa Strakhovanie. He is also a Member of the Economy, and Why It Matters for Global Capitalism". Princeton University Press. Scientific Council of the Brussels-based think tank BRUEGEL and of the Advisory Council of the Åslund, Anders, Sergei Guriev and Andrew Kuchins Peterson Institute of International Economics. (2010). "Russia after the Global Economic Crisis".